The Euro Crisis Is Back! (Actually, It Never Really Left)

By Matthew O'Brien

A lonely continent turns its eyes to Mario Draghi and the ECB to stop the latest round of Euro panic.

Reuters

Meet the new crisis. Same as the old crisis.

After a quiet-ish few months, Euro panic came back in a big way on Tuesday. Spanish stocks hit a three-year low. Spain's bond yields crept back up above 6 percent. It wasn't any better in Italy, whose stocks fell 5 percent. That's a lot of bad news on a day with seemingly no new news. What's going on here?

We thought the Euro crisis was over. We were wrong. Euro leaders just kicked the can down the road. Inexplicably, they confused this for the end of the road. But now the can needs to be kicked again. Either that, or Europe needs to come up with a genuine plan to end the crisis. Time to kick the can, again.

THE CRISIS IN THREE PARAGRAPHS

Most explanations of the Euro debt crisis are about government spending. That's not accurate. The real story is all about capital flows within Europe. During the boom years, money poured into "southern" Europe. Sometimes governments borrowed it. Sometimes the private sector did. It didn't much matter which did. The result was the same: soaring wages and unsustainable growth. Once Lehman failed, though, the money spigot turned off. Southern Europe's economies promptly collapsed. So too did tax revenue. That left them with swelling deficits and uncompetitive labor forces due to too-high wages.

There's usually an escape valve for economies facing what economists call a "sudden stop": a cheaper currency. That lets them swiftly cut real wages and export their way back to health. But euro membership makes this impossible. That's left Europe's weak countries with no plausible path back to growth. At best, it takes years to get workers to accept nominal pay cuts. Prolonged stagnation from such an "internal devaluation" -- that is, pushing wages down and unemployment up -- has created the very real possibility that these countries might literally run out of euros. After all, they can't print euros themselves. Only the ECB can do that. And that has produced self-fulfilling fears. Investors worry that other investors are worried, and dump sovereign bonds. Borrowing costs surge. That pushes governments to cut even more spending, which kneecaps growth, which worries investors even more. And so on, and so on.

The final piece of this doomsday puzzle is Europe's banks. They hold huge amounts of sovereign debt. As bonds sell off, that makes banks look riskier. The riskier banks look, the more likely it is that they'll need to be bailed out. And the more likely that they need to be bailed out, the riskier Europe's sovereigns look. It's a negative feedback loop only a Eurocrat could dream up.

THE WAY OUT IN THREE STEPS

Any credible plan to end the Euro crisis must address three issues. First, it has to end the panic. Second, it has to help southern Europe regain competitiveness, preferably without forcing them into mass bankruptcy. And third, it needs to revamp Europe's institutions so this doesn't happen again.

So far, Europe's leaders have done the first and called it a day. The ECB managed to kick the can back in December by shoveling essentially unlimited amounts of free money at Europe's banks. Of course, Europe's leaders not-so-subtly encouraged the banks to invest their new free money in sovereign bonds, which brought borrowing costs down to manageable levels. It would have been easier to give the money to countries directly, but the ECB worried about possible moral hazard. In other words, countries wouldn't have any incentive to cut spending if they knew the ECB would bail them out. It was an easier sell to funnel money through the banks first. And ultimately, it didn't really matter whether the ECB gave free money to the banks or to sovereigns. What mattered was that they short-circuited the doom loop between the two. Regrettably, Europe's leaders interpreted the subsequent reprieve as a pardon.

But now the panic is back, thanks to the end of the free money and the renewed push for austerity in Spain and Italy that has renewed doubts about growth. Fortunately, the ECB can stop this whenever it wants. That's the magic of the printing press. The ECB can promise to keep Spain and Italy's borrowing costs below a certain threshold as long as they stay on track with their fiscal and structural reforms. Alternatively, the ECB can stuff the banks with even more free money.

Whenever the ECB does inevitably kick the can again, it's critical that Europe's leaders don't waste their borrowed time again. Planning on Spain and Italy to cut wages by some 20 to 30 percent is not a plan for anything but disaster. It won't work. Northern Europe needs to either accept slightly higher inflation or tax policy that mimics higher inflation. So far they haven't been willing to do so. My magic-eight ball says that's not likely to change, either. In the long-term, Europe needs to create the kind of centralized treasury and labor markets that are necessary to make a currency union work. That's a long, long way off though.